Deposit Insurance

What is the state of the art in understanding deposit insurance? I am interested in survey articles that cover thinking in the last twenty years or so.

Suppose we start with a distinction between a solvency problem and a liquidity problem. If the bank is insolvent, it has negative net worth. If it is illiquid, it has positive net worth but if faced with a run would have to sell assets at prices below their true value, so it cannot meet depositor needs.

1. I suspect that the case for using deposit insurance to protect banks that are illiquid is better than the case for using deposit insurance to protect depositors against insolvency. Protecting depositors against insolvency can work out to be a pure transfer from taxpayers to bank owners, assuming that bank owners figure out how to maximize the value of their put option--that is, the option to put the bank back to the insurance agency.

2. I suspect that it is hard to structure deposit insurance so that it protects against illiquidity without protecting against insolvency.

3. I suspect that there are contractual arrangements that address the problem of illiquidity that are better than deposit insurance. That is, there are arrangements that take away the incentive to participate in a bank run while not giving the bank owners a put option with respect to the insurance agency.

4. One obvious contractual arrangement would be a money market mutual fund in which "breaking the buck" is not viewed as something unthinkable. Gosh, if we were typically running inflation of 1 percent a month, then a money market mutual fund that had a yield of less than 1 percent a month would be doing the same thing as a money market fund that broke the buck in a zero-inflation environment, no?

I am thinking about this in the context of government financial guarantees in general. It strikes me that deposit insurance is the government guarantee with the strongest case. If that case is weak, then the case for other guarantees is likely to be weaker.

Comments and Sharing

In my mind, one of the benefits of FDIC is that everybody understands it. Anything clever that the government did instead would have to be similarly easy to understand by the plebes.

Also, is it possible that rather than being an income transfer, it's simply a case where bankers get a larger share of the created value. I may be mistaken, but I haven't seen many banks USE their put option, even if they are relying on it.

Why can't the private sector provide the insurance? Banks could by insurance against runs and depositors could by insurance against insolvencies. What's so hard about that?

That's actually fairly close to how to FDIC works. The banks pay into the insurance fund, not the taxpayers. Part of that is to keep it off-budget, I'm sure. Then congress realized they could get a bunch of other bank regulation done for free off-budget and piled that on too.

Personally, I'd prefer the insurance company not be profit driven/privately held like fannie and freddie. At some point you need an organization with a clear stability mandate. Stability isn't going to emerge for free, it seems.

I don't think of the FDIC as doing much to provide liquidity. It's intended to shut down insolvent banks before hurt their depositors too much. This mitigates the pressure from depositors of a bank run, true. The Fed is more focused on dealign with illiquidity, no?

If a bank is under unbearable pressure from a run, it will usually claim that it is solvent but holds illiquid assets. But how is a government agency to assess such a claim? The existence of illiquid assets--assets which one has to expect to draw a sale price less than their true value if they had to be sold quickly--is simply a market imperfection. Government's ability to correct market imperfections is very limited. If the market can't correctly price the bank's assets, why think the government can do so? Hence: "[I]t is hard to structure deposit insurance so that it protects against illiquidity without protecting against insolvency."

"[I]f we were typically running inflation of 1 percent a month, then a money market mutual fund that had a yield of less than 1 percent a month would be doing the same thing as a money market fund that broke the buck in a zero-inflation environment, no?" Yes, life is so much tougher (for money-market funds and for a lot of other people) in a low-inflation environment--the lower, the tougher. The ideal inflation level must be some fairly substantial positive number: 3%, 4%, or the like. Let us hear no more about the "ideal" of zero inflation!

(Regarding scholarly articles on the topic: you have better resources than I have for finding them.)

This is a bit more on history and less on theory, but it is closer to what you are looking for than any of the other comments. It is a paper that Randy Kroszner and I wrote for the Deposit Insurance Around the World volume edited by Demirguc-Kunt, Kane, and Laeven and published by MIT Press. I cannot find your email, otherwise I would send the article to you directly.

Will Melick

[Hi, Will. Thanks! You can always post a url to your paper or the book here on EconLog, or you can email us--and Arnold--at webmaster@econlib.org. Our Contact info is displayed on all our webpages. Any email intended for individual bloggers is promptly directed to them.--Econlib Ed.]

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